Macro Tsimmis

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Archive for July, 2012

Nothing to see here: 2Q12 volatility doubles, but only to average levels

Posted by intelledgement on Thu, 12 Jul 12

Bouncing off the lowest quarterly reading in six years, volatility in the second quarter of 2012 (2Q12) was up 115% quarter-over-quarter…but that only brought it to slightly-above-normal levels. For 2Q12, the average daily change in the value of the S&P 500 index was ±0.76%, compared with ±0.35% in 1Q11.

We track market volatility because it is a reasonably reliable gauge of risk levels. 74% of the time from 1950 to 2012, when volatility in the S&P 500 goes up—that is, the average annual daily change in the price of the index (up or down) is greater than it was in the prior year—market performance declines. And when volatility declines year-over-year, market performance improves 57% of the time. And so far, 2012 is no exception: the S&P 500 index volatility of ±0.56% for the first six months is down 44% from the ±1.00 volatility we experienced in 2011…and market performance has materially improved from flat in 2011 to +8% so far in 2012.

Normally, the market is remarkably stable. On average, the S&P 500 index rises or declines 0.62% each day the market is open. Actually, 52% of the time, the change in the value of the index rounds to 0% (that is, the change is less than one-half of one percent). Another 38% of the time, the change rounds to 1%.

Thus, the ±0.56% level of volatility we have seen so far in 2012 is below average. If this level were to hold for the entire year, 2012 would then feature the least annual volatility since 2006 (±0.45%), which is to say, since before the 2008 crash. Here is a chart that shows annual volatility levels for the past 60 years:

After the 2008 crash, many analysts wondered if we were in for a replay of the 1930’s depression. In terms of volatility, 1929 was every bit as extreme for the DJIA as 2008 was for the S&P 500 (which itself was not created until after WWII, which is why we rely on the Dow for the 1929 data). Following the 1929 crash, volatility immediately declined sharply from the crash peak to a near-normal level in 1Q30, but then began a jig-jaggy climb that lasted through 1930 and 1931 and into 1932, peaking in 3Q32 at a level (±3.00% on average, every day the market was open!) even higher than 4Q29 had reached.

But the post-2008 pattern has been starkly—and hearteningly—different. Here is chart that compares market volatility for the two crashes:

While the extreme volatility of 4Q08 (±3.27% up or down every day the market was open!) topped anything from the Depression, in three-plus years since then, we have not come close to replicating those heights. And more importantly, the post-crash market performance has been like day (this time) compared to night (post-1929):

1929 -16% 2008 -38%
1930 -34% 2009 23%
1931 -53% 2010 13%
1932 -23% 2011 0%
1933 64% 2012 8%

Of course, the +8% for 2012 is just for the first half of the year; a lot could change. Just last year, the S&P 500 index was up 5% at the half-way point but declined in the last six months of the year to close flat overall for 2011. Indeed, volatility is not predictive. That is, frenetic trading does not generate a black swan event; it’s the other way round. Clearly the combination of increased longer-term risk in the USA-highlighted by continuing budget and deficit issues and seeming political deadlock exacerbated by 2012 being an election year-and potential danger of sovereign debt default in Europe with the concomitant systemic risk of large bank failures, and the potential for a hard landing in China, plus macropolitical tensions (e.g., Iran, North Korea) all continue to be challenges.

The relatively quiescent first half of 2012 may yet prove merely to be the calm before the storm. But so far, inasmuch as the market reflects the combined wisdom of us investors, clearly our consensus is that we have dodged the Depression bullet, and despite the lurking dangers and risks, we are still expecting rabbits to be pulled out of hats and the cavalry to arrive in the nick of time to save the day. Stay tuned for further updates.

Previous volatility-related articles:

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Guest Post: There’s A Larger, Scarier Fiscal Cliff That No One Is Talking About

Posted by intelledgement on Wed, 11 Jul 12

by Peter Schiff, Euro Pacific Capital

The media is now fixated on an apparently new feature dominating the economic landscape: a “fiscal cliff” from which the United States will fall in January 2013. They see the danger arising from the simultaneous implementation of the $2 trillion in automatic spending cuts (spread over 10 years) agreed to in last year’s debt ceiling vote and the expiration of the Bush era tax cuts. The economists to whom most reporters listen warn that the combined impact of reduced government spending and higher taxes will slow the “recovery” and perhaps send the economy back into recession. While there is indeed much to worry about in our economy, this particular cliff is not high on the list.

Much of the fear stems from the false premise that government spending generates economic growth (for stories of countries experiencing real growth, see the remainder of our latest newsletter). People tend to forget that the government can only get money from taxing, borrowing, or printing. Nothing the government spends comes for free. Money taxed or borrowed is taken out of the private sector, where it could have been used more productively. Printed money merely creates inflation. So the automatic spending cuts, to the extent they are actually allowed to go into effect, will promote economic growth not prevent it. Even most Republicans fall for the canard that spending can help the economy in general. But even those who don’t will surely do everything to avoid the political backlash from citizens on the losing end of any specific cuts.

The only reason the automatic spending cuts exist at all is that Congress lacked the integrity to identify specifics. Rest assured that Congress will likely engineer yet another escape hatch when it finds itself backed into a corner again. Repealing the cuts before they are even implemented will render laughable any subsequent deficit reduction plans. But politicians would always rather face frustration for inaction than outright anger for actual decisions. In truth though, only an extremely small portion of the cuts are scheduled to occur in 2013 anyway. If it comes to pass that Congress cannot even keep its spending cut promises for one year, how can they be expected to do so for ten?

The impact of the expiring Bush era tax cuts is much harder to assess. The adverse effects of the tax hikes could be offset by the benefits of reduced government borrowing (provided that the taxes actually result in increased revenue). But given the negative incentives created by higher marginal tax rates, particularly as they impact savings and capital investment, increased rates may actually result in less revenue, thereby widening the budget deficit.

In reality, the economy will encounter extremely dangerous terrain whether or not Congress figures out a way to wriggle out of the 2013 budgetary straightjacket. The debt burden that the United Stated will face when interest rates rise presents a much larger “fiscal cliff.” Unfortunately, no one is talking about that one.

The current national debt is about $16 trillion (this is just the funded portion…the unfunded liabilities of the Treasury are much, much larger). The only reason the United States is able to service this staggering level of debt is that the currently low interest rate on government debt (now below 2 per cent) keeps debt service payments to a relatively manageable $300 billion per year.

On the current trajectory the national debt will likely hit $20 trillion in a few years. If by that time interest rates were to return to some semblance of historic normalcy, say 5 per cent, interest payments on the debt would then run $1 trillion per year. This sum could represent almost 40 per cent of total federal revenues in 2012!

In addition to making the debt service unmanageable, higher rates would depress economic activity, thereby slowing tax collection and requiring increased government spending. This would increase the budget deficits further, putting even more upward pressure on interest rates. Higher mortgage rates and increased unemployment will put renewed downward pressure on home prices, perhaps leading to another large wave of foreclosures. My guess is that losses on government insured mortgages alone could add several hundred billion more to annual budget deficits. When all of these factors are taken into account, I believe that annual budget deficits could quickly approach, and exceed, $3 trillion. All this could be in the cards if interest rates were to approach a modest five per cent.

If the sheer enormity of the red ink were to finally worry our creditors, five per cent interest rates could quickly rise to ten. At those rates, the annual cost to pay the interest on the national debt could equal all federal tax revenues combined. If that occurs we will have to either slash federal spending across the board (including cuts to politically sensitive entitlements), raise taxes significantly on the poor and middle class (as well as the rich), default on the debt, or hit everyone with the sustained impact of high inflation. Now that’s a real fiscal cliff!

By foolishly borrowing so heavily when interest rates are low, our government is driving us toward this cliff with its eyes firmly glued to the rear view mirror (much as the new French regime appears to be doing). For years I have warned that a financial crisis would be triggered by the popping of the real estate bubble. My warnings were routinely ignored based on the near universal assumption that real estate prices would never fall. My warnings about the real fiscal cliff are also being ignored because of a similarly false premise that interest rates can never rise. However, if history can be a guide, we should view the current period of ultra-low rates as the exception rather than the rule.


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